Plan to Retire Someday? You’ll Want One of These

By Susan Gregory Thomas

March 11, 2013

If “retirement account” translates to you as “no comprendo,” you’re in distinguished company. Celebrated writer E.B. White famously wrote a scathing essay assailing the government for making even basic tax forms impossible to figure out.

The takeaway is the same here: You’re not stupid—or alone—if you get tripped up by all the retirement gobbledygook. Here’s our straight-up guide to the six major types of retirement accounts. Read on and start saving!

TRADITIONAL IRA

What it is: An acronym for “Individual Retirement Account,” a traditional IRA is a retirement savings account. If you (or your spouse) earn taxable income and are under age 70 ½, you can open an IRA and start contributing to it pronto. Your money won’t be taxed until you start withdrawing—as long as it’s not earlier than age 59 ½. If you take money out before then, you’re charged a 10% penalty and you’ll owe taxes as well.

How it works: There are two types of traditional IRAs: deductible and nondeductible. Most people qualify for a deductible IRA—a good choice because you can deduct your contributions on your tax return (lower tax bills—yay!). For 2013, you can save up to $5,500 in your IRA, $6,500 if you’re 50 and over.

In some cases, if you’re contributing a certain amount to an employer-sponsored retirement account like a 401k, you’d have to open a nondeductible IRA. The contribution limits are the same, but you wouldn’t deduct them.

Good plan, if you’re… pretty sure you’ll retire before age 70 ½ (when you are required to start taking distributions from traditional IRAs and pay income taxes on the amount distributed), or that you’ll be in a lower tax bracket than you are now once you’re over age 70 ½. You’ll not only be able to take those tax deductions now, if you qualify, but you’ll also be in that lesser bracket in retirement—hence, fewer taxes, period.

ROTH IRA

What it is:Roth IRAs are funded with money you’ve already paid taxes on; but because of that, your money grows tax-free and when you withdraw at retirement (assuming you have had the account opened for at least five years and are 59½ or older), you pay no taxes. Period.

How it works: Roth IRA contributions are limited by income level: $188,000 for married couples filing jointly; $127,000 if you’re filing as single or head of household. You can contribute up to $5,500 for 2013; $6,500 if you’re 50 and older.

You can contribute to both a Roth and a traditional IRA, but the total can’t be more than $5,500 (or $6,500 if you’re 50 and older), to keep the respective tax benefits of each account.

Good plan, if you’re…pretty sure you’ll be in the same or an even higher income bracket when you retire and those tax-free withdrawals will mean a lot. (Remember, you pay taxes on withdrawals from most other retirement accounts.)

Also, having a Roth can help you stagger your retirement income because unlike a 401k or traditional IRA, you’re not required to start taking withdrawals at 70 ½, which means your money keeps growing, tax-free.

Another advantage: Because Roth contributions are after-tax dollars, the government cuts you a break on early withdrawals—i.e. before age 59 ½. If you think you might need some of that cash to pay for education (kids, grandkids, even you or your spouse); have medical bills totaling more than 7.5% of your annual income; or need a down payment for a first house (no more than $10,000); you can take out the money you’ve contributed (although not the earnings) penalty-free, as long you’ve had the account for five years.

SEP IRA

What it is: An acronym for Simplified Employee Pension, a SEP IRA is a traditional IRA for people who are self-employed or run small businesses. If you fit this description—even if you have a company that only employs one person—you can open one. However, your employees can’t put money in. So if you’re the small-business employer, you must contribute to all employees who have worked for you for three of the past five years.

How it works: They money you contribute is tax-deductible for the business (or for you if you’re a freelancer), and it goes into an account that’s similar to a traditional IRA in that the money isn’t taxed until withdrawal. You can open a SEP at almost any bank or financial institution. You’re allowed to contribute as much as 25% of your self-employed income (up to a max of $51,000 for 2013).

There are some restrictions if you’re an employer contributing to your employees’ accounts.

Good plan, if you’re…self-employed; or a small business employer who wants an easy-to-manage retirement account that rewards employees and has the highest contribution limits of all small business IRAs.

SIMPLE IRA

What it is: The Savings Incentive Match Plan for Employees is a type of traditional IRA for small businesses and self-employed people that lets employees make contributions.

How it works: SIMPLE IRAs require employers to make contributions on employees’ behalf (either a dollar-for-dollar match of up to 3% of the employee’s salary or a flat 2%).

Employees can contribute up to $12,000 in 2013; $14,500 if you’re 50 and over.

The rules governing the employer’s contribution are somewhat complicated, so read up on your IRS rules before deciding on this plan for your company.

Good plan, if you’re…a small business employer who wants a low-cost, easy-to-manage employee IRA account. If you’re self-employed a SEP IRA is probably a better choice, as the contribution limits are higher.

401(k)

What it is:401(k)s and their ilk—403(b)s, 457s and Thrift Savings Plans (TSPs)—are offered, typically, to employees of mid- to large-sized companies, non-profits, federal, state and local governments.

As an employee, you decide how much you want to sock away, and your employer deposits that money into your account for you—and better yet, may even match some or all of your contributions up to a certain amount (usually no more than 6%, but it’s still free money—HELLO!).

How it works: The percentage of your salary you've decided to contribute to your 401(k) is deducted from your paycheck, pre-tax. The contribution limit for 2013 is $17,500. You pay taxes on the money when you withdraw it in retirement.

Your employer offers a selection of investment options, usually mutual funds and/or target date funds. When you leave your job, you keep the 401(k), usually by rolling it over into what’s called a rollover IRA.

You can’t withdraw money from your 401k, but you can take out a 401k loan—although you must pay it back, or get hit with penalties, taxes, and interest.

Good plan, if you’re…working at a company or organization that kicks in some of its own money into your account. Be warned, however, that if you leave and are not yet vested, your employer has the right to keep their contributions to your 401(k). Your former employer also might not let you keep your 401(k) money if your balance dips below $5,000 and you haven't rolled it over to an IRA.

ANNUITIES

What it is: An annuity is an insurance product that is designed to provide a steady stream of income for life or for a certain amount of time, and is typically used in retirement.

How it works: There are two basic types of annuities: deferred and immediate. With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement. With an immediate annuity, you begin to receive payments soon after you make your initial investment. For example, you might consider purchasing an immediate annuity as you approach retirement age.

Annuities come in many flavors, however, so this is one account where you’d benefit from the advice of an advisor. Some give you steady payouts, some vary according to market returns. If you want an annuity, it can offer some security, but you have to pick the right product for you.

Good plan, if you’re…either: 1) maxed out on contributions to other tax-friendly retirement accounts (such as 401(k) plans and IRAs); or 2) nearing retirement without much savings to show for it, and you need to catch up in a hurry; or 3) interested in guaranteeing a particular amount of income in retirement.

Beware, however, of the foggy fees and confusing features that surround annuities. They often come with a number of high fees and restrictions, and can result in handsome commissions for the insurance agent—one of the many reasons unscrupulous agents may sell you on annuities’ advantages without fully explaining the downsides. Caveat emptor, sister.